Q&A: Why Italian election has shaken investors

Italy's inconclusive election has rattled markets and raised the fear that Europe's crisis over too much government debt could flare again after several months of calm.

European stocks fell sharply Tuesday and Italy's borrowing costs climbed after voters rejected the austerity policies and reforms of the former Prime Minister Mario Monti.

Yet no political group won enough seats to control both houses of parliament. In the voting, a center-left alliance led by Pier Luigi Bersani won control of the lower house, barely beating the center-right alliance of former Prime Minister Silvio Berlusconi. Bersani's forces did not win control of the Senate upper house, not even with the help of a small group led by Monti

Much remains uncertain: how long it will take to form a government, whether it will be solid enough to pass legislation, and whether it would keep Monti's pro-growth reforms.

If nothing works out, there could even be new elections.

Here are questions and answers about why all that worries people elsewhere in Europe and beyond.

Q: Why all the investor alarm?

A: Above all, investors are afraid the eurozone will go back to where it was last July.

Then, doubts about the ability of heavily indebted euro countries Spain and Italy to manage their debts raised the specter of a government defaulting on its bond payments and spreading financial turmoil across Europe.

It was only when the European Central Bank offered to buy unlimited amounts of an indebted country' bonds that the crisis abated.

Q: Are there other worries?

A: Italy is an important partner in fixing the euro's deeper problems such as creating an EU banking supervisor that could strengthen the region's financial system. Having the third largest country politically paralyzed will slow down an already drawn-out process.

New elections could bring an anti-euro government into power. Former comedian Beppe Grillo, leader of the third-placed Five Star Movement protest party, has talked about a referendum on euro membership.

Q: What's wrong with Italy?

A: Its economy isn't growing, unemployment is sky-high and its debt burden is rising.

Italy adopted the euro as its currency in 1999 with a lot of debt, which it carried easily for years it just sold new bonds to pay off old ones that came due.

The problem is that Italy's economy has grown very slowly in recent years and has been in recession for 18 months.

The economy is held back by labor rules that favor vested interests such as unions and established workers but kill off job prospects for younger people; high business taxes, and government red tape.

Q: What does Italy's election stalemate mean for Europe?

A: The result is a firm rejection of how Europe's politicians have tackled the debt crisis so far. That strategy, pushed by Germany, has been to offer indebted countries help, provided they agree to tough austerity. Greece, Portugal and Ireland have been bailed out and have had to make deep cuts.

Some say that strategy hasn't been working: the cuts in spending have contributed to high unemployment and recession.

"The politics of the current strategy for coping with the eurozone are looking increasingly fraught and unworkable," said Simon Tilford, chief economist at the Center for Economic Reform in London.

But Italy's elections could have a silver lining, he added. "On a positive note, if it leads to a rethinking of this approach, then it could be positive for the future of the currency union."

Q: If the ECB is on standby with its offer to buy bonds issued by struggling countries, why would it matter if Italians say no to austerity?

A: The ECB stressed that for it to buy an indebted country's bonds, that country must agree to take steps to reduce its deficit and ask for help from the eurozone's bailout fund.

If a government can't or won't agree to an austerity plan, the ECB can't help. Hence the concern that the eurozone debt crisis could return.

Q: What could happen next?

A: Worst case: Analysts at Capital Economics in London see a worsening of Italy's financial situation and an eventual move for a bailout. That would probably be preceded by serious financial turmoil that would drive whatever government is in charge to agree to one.

Others, however, think the post-election market turbulence will be temporary.

Analysts Joerg Kraemer and Ulrike Rondorf at Commerzbank point out that Monti had already pushed through all the cuts and pro-growth reforms he could.

A government that does nothing "need not be all that bad for fiscal policy, because it is unlikely that the tax cuts frequently demanded during the election campaign will be passed in the near future," they wrote.

While growth reforms are still needed, inaction would be "no dramatic change compared with the situation under the Monti government."

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